Financial services: regulation, costs and maybe fintech

In a briefing to financial services chiefs in New York last month, Cayman Finance CEO Jude Scott offered a modest headline: The jurisdiction is looking at streamlining compliance issues using fintech, a software-based financial-tracking system.

Along the way, Scott also announced formal elevation of the reinsurance industry to Cayman’s formal industry sector – the sixth alongside banking, investment funds, insurance, corporate services and trusts, reflecting its growth in the last year, and hopes for greater 2017 development.

“The development of our reinsurance sector is just one area of innovation that we have been focusing on over the past 12 months,” Scott said.

“We have also been looking very closely at the fintech industry and specific aspects of fintech that fit synergistically with the overall Cayman business model.”

A rapidly growing sector in itself, fintech refers to software-based applications that streamline numerous financial transactions including stock trading, investment, peer-to-peer lending and standard retail banking functions such as traditional lending and management of portfolios and personal finances. Fintech is used among banks and their business and retail clients, and small businesses and their clients.

Fintech can also be used to streamline compliance, although “blockchain” a potential regulatory boost, has created a host of problems by making possible the unregulated, extra-institutional spread of bitcoin currency, which is sometimes associated with criminal activity.

A framework of laws, developed under both Cayman Finance and the Cayman Islands Monetary Authority, might direct fintech toward a more institutionally based market, a “system based on entities,” Scott said earlier.

Blockchain, an “open, distributed ledger” (also called a “common ledger”) “can record transactions between two parties efficiently and in a verifiable and permanent way,” according to January’s Harvard Business Review, and thus could become a “standard place for verifying the credentials of customers.”

“With blockchain, we can imagine a world in which contracts are embedded in digital code and stored in transparent, shared databases, where they are protected from deletion, tampering and revision,” the Business Review says. “ … Every agreement, every process, every task and every payment would have a digital record and signature that could be identified, validated, stored, and shared … This is the immense potential of blockchain.”

“To ease the way to that future,” the Wall Street Journal reported, “[Scott] advocates global standards for key areas of compliance such as money laundering.”

Regulatory compliance

Regulatory compliance regarding anti-money laundering will raise its head again later this year, Cayman Islands Attorney General Sam Bulgin told an audience at the Jan. 11 opening of the court year. The Trinidad-based Caribbean Financial Action Task Force, he said, would visit Cayman for a “mutual evaluation” of the long-standing 40 AML recommendations made by the organization’s FATF Paris-based parent – a division of the Organization for Economic Cooperation and Development.

The timing of the visit is of particular interest to local bankers, who are worried about the detailed preparations it entails. Fidelity CEO Brett Hill said he was aware of the “upcoming review,” but didn’t know which banks would be selected … if any.

A visit from the International Monetary Fund also looms this year, “but at this stage this has not involved Fidelity,” he said.

In 2015 and 2016, Fidelity undertook “a full AML/CFT [combatting financing of terrorism] review, including a review of all client files” which Hill described as “an extremely costly and time-consuming exercise.”

Fidelity also completed a formidable list of additional surveys, he said, including the Foreign Account Tax Compliance Act; United Kingdom, Crown Dependencies and Overseas Territories international tax compliance regulations; implementation of Common Reporting Standards; the Basel II Internal Capital Adequacy Assessment Process, requiring minimum liquidity requirements; and a series of risk assessments.

Fidelity was not alone in navigating stiff regulatory challenges. Bulgin’s Jan. 11 address came immediately after meeting a three-member OECD panel from the Global Forum on Transparency and Exchange of Information for Tax Purposes.

The meeting marked the end of a 72-hour visit assessing Cayman’s implementation of international standards for sharing tax information formally sought by other jurisdictions.

Minister of Financial Services Wayne Panton said the results are due later this year. “We now look forward to working with the Global Forum over the coming months to finalize the report. Given our track record on tax cooperation over the years, we remain optimistic that our regime is in line with global standards,” he said.

“Notwithstanding the numerous confirmations and validation of the soundness of our regulatory standards, there are still some foreign organizations that continue to perpetuate their jaundiced criticisms about our regulatory framework,” he told the courtroom gathering.

“Most of the critics are persons or entities who are just not familiar with the nature of the industry. But … we will continue to highlight the fact that our standards are consistent with, and in some cases, exceed international thresholds,” he said.

Just two weeks ago, in U.S. Senate hearings, legislators accused Treasury Secretary-designate and former Goldman Sachs partner Steve Mnuchin, of sheltering money in the Cayman Islands “tax haven.”

“As Treasury Secretary … would you support closing tax loopholes in the tax code that … extremely wealthy people … – such as yourself – have used to avoid paying taxes?” Sen. Deborah Stabenow asked.

“I would support changing the tax laws to make them simpler and more effective, yes,” Mnuchin answered, saying he “did not use a Cayman Islands entity to avoid paying taxes for myself.”

“So you helped others avoid paying?” Stabenow replied.

Ingrid Pierce, Walkers Global Managing Partner, echoed Bulgin’s sentiments: “The role of international financial centers continues to be misunderstood or misreported in certain quarters, so the efforts of governments, financial services industry groups and the IFC Forum are key [to] bringing balance and fairness to the debate.”

New financial services laws

Bulgin’s legal acumen is likely to be instrumental in the introduction next month of new financial-services laws into the Legislative Assembly.

Starting on Feb. 22, the roster includes amendments to the 2003 Companies Law, requiring firms to create internal beneficial ownership registers, and concomitant changes to the 2016 Limited Liability Companies Law, which will also require local firms to “establish and maintain” registers of beneficial ownership.

Other financial services legislation will allow “formation and registration” of limited liability partnerships, and “a bill for a law to amend the Trusts Law (2011 Revision).”

Beneficial ownership has loomed as a global issue for years as regulators have sought to eliminate “secret” rosters of company owners, seeking to preserve privacy, anonymity and even protection from taxation and legal inquiry.

In early 2014, Premier Alden McLaughlin appeared on BBC’s “HARDtalk,” defending Cayman’s regulatory regime, telling host Stephen Sackur that he would embrace a public ledger of beneficial ownership when other jurisdictions did.

Since then, negotiations have slowly eroded fierce resistance to a public account, arriving at a compromise whereby beneficial owners will be named on a centralized list, searchable only by a local “competent authority,” and released only to U.K. law enforcement.

“The proposals are to be welcomed as constructive and positive and would strike a sensible balance by enabling law-enforcement authorities to have access to the information they need in cases where people abuse the corporate veil, while continuing to protect the privacy of legitimate commercial interests and individuals,” said Harneys Managing Partner Jonathan Culshaw, writing with partners Ian Gobin and Sean Scott.

Harking to Cayman Finance fintech proposals, the authors observed that a timetable for implementation was unclear: “As the platform will require a new, secure IT system to be developed by the government, and corporate service providers [must] develop their IT systems to allow the platform to connect to the beneficial ownership registers they maintain, this timetable could be challenging.”

Further delays may result as “secondary legislation is also expected to be published to expand on some aspects of the proposals,” the trio wrote.

“The platform … will enable a senior official designated by the Cayman Islands ministry to access [the] information – already collected and held by corporate services providers in the Cayman Islands – and to provide it to the UK’s National Crime Agency following a lawful request by the latter.”

Both Frew and the Harneys trio named June for implementation.

“The platform is intended to facilitate expedited access from June 2017,” Frew said, with Cayman required to respond within 24 hours.

“Having invested in state-of-the-art technology and infrastructure in order to maximise the efficiency, speed and quality of our services, we are perfectly placed to facilitate clients’ compliance with the proposed legislation on a cost-effective basis,” she said.

Intimately related are the amendments to the 2016 Limited Liability Law – modeled on legislation in the U.S. state of Delaware – which created a hybrid of Cayman Islands exempted companies and Cayman Islands exempted limited partnerships, and mostly employed as holding companies and both special-purpose and joint-venture vehicles.

Since introduction of the law last year, investors have formed more than 200 LLCs, according to Walkers Partner Melissa Lim, who said advantages “included flexibility in terms of modifying the applicable fiduciary standards … the ability to create sole-member-managed LLCs … The organisational documents may also be simplified.

“Accordingly,” she said, “we expect that the use of Cayman LLCs will increase over time.”

The 2017 amendments will ensure LLCs abide by emerging beneficial ownership standards. The tightening regulation in aid of global tax compliance creates a kind of “approach-avoidance” dilemma for the financial-services industry – which craves international approval, yet resists attendant restrictions.

More regulation

Yet, more regulation is in prospect, underlined internationally by fresh changes to OECD common reporting standards.

The move toward CRS only came in 2013 when G-20 leaders endorsed OECD proposals for automatic, standardized, annual exchanges of information among tax jurisdictions.

Approved in mid-2014, the standard, according to the OECD website, “calls on jurisdictions to obtain information from their financial institutions and automatically exchange that information with other jurisdictions … It sets out the financial-account information to be exchanged, the financial institutions required to report, the different types of accounts and taxpayers covered, as well as common due diligence procedures to be followed by financial institutions.”

Last year was the first for CRS for Cayman financial institutions, according to Harneys Partner Matt Taber, who says certain information is due at government’s Department of International Tax Cooperation by May 31.

The changes are complex but fall in four broad areas: Registration requires all local financial institutions to register with the DITC, providing “certain information” by April 30, including contact details for an individual designated as the principal point of contact; nil returns require financial institutions to file tax returns for all reportable jurisdictions even if they have no reportable accounts in those jurisdictions; a clear requirement for written policies and procedures requires financial institutions to “establish, implement and comply with written policies and procedures to cover all of their obligations under the regulations,” meaning the DITC expects complete documentation when it takes compliance or enforcement action; and new offenses and penalties introduces such offenses as “providing materially inaccurate information, tampering with information and hindering the Tax Information Authority in its functions.” Criminal liability can result, accompanied by fines as high as US$60,975.

The DITC has pledged to issue guidance notes by March for the changes, which Taber says demonstrate “Cayman Islands’ continued commitment to implementing international transparency standards as well as their willingness to legislate in order to maintain Cayman’s position as a leading international finance center.”

The regulations, he says, will allow Cayman to meet its CRS obligations, but Walkers’ Pierce notes that the costs of compliance with growing regulation continue to escalate.

“Clients are responding in different ways,” she says. “Established managers with good infrastructure are usually able to defray these costs and have either built their systems or are in the process of improving their systems to cope with new regulations and best practices.

“Smaller or newer managers may need seed capital or to join forces with a larger platform through which they can offer their product. We have also seen clients outsourcing various roles which they cannot realistically take on full-time in house.”

She said the advent of CRS – and FATCA and the Alternative Fund Managers Directive – proved to be major issues in 2016.

“Another big driver,” she said, “is market expectation around best practices, driven in large part by institutional investors. This, coupled with an overall increase in regulation, means there is probably more focus on regulatory compliance than ever before.”

Meanwhile, the legislature is scheduled to grant new enforcement powers to the Cayman Islands Monetary Authority, allowing it to impose fines for the first time.

Under the Banks and Trust Companies Law, the Companies Management Law, the Mutual Funds Law, the Securities Investment Business Law and the Directors Registration and Licensing Law, CIMA will be able to impose fines, ranging from $1 million to spot fines, to ongoing daily penalties of $5,000, for breaches of money-laundering regulations or violation of any of the five related laws.

Fidelity’s Hill laments regulatory growth if only because of compliance costs – and observed that the new U.S. president has pledged to slash bureaucracy.

“Depending of course on what steps Mr. Trump takes, we believe that regulation is likely to continue to increase and therefore the cost of doing business will rise,” he said.

“Having said that, we’re hopeful that profitability will increase with the economic recovery and growth of our business.”

Pierce agreed: “The cost of infrastructure and regulatory compliance continues to hamper the start-up environment,” noting “the funds market is more competitive and in a low-growth environment there is continued pressure on fees. This means that managers are looking at non-traditional structures and strategies and in some cases taking more risk in order to increase the chances of higher returns.

“In terms of growth areas, we continue to see credit funds and managers looking more towards emerging markets. We are also starting to see the resurgence of an appetite for distressed or otherwise illiquid assets,” she said.

Hill pointed to a looming, if under-reported problem: “Don’t forget correspondent banking. That is a major threat to the region, but the financial sector, including [Cayman’s] Ministry of Finance, is aware of it and is taking steps to deal with it before it becomes a problem for Cayman.

“The reality is that such bodies as the IMF, FSB and FATF understand the need [for] large U.S. banks to continue to offer correspondent banking services and have publicly stated this position. However, some of the large correspondent banks have been hit with significant fines by the Department of Justice and are seeking to de-risk.

“There is also a compliance cost associated with offering these services, so it’s not just about de-risking; it’s also a business decision,” Hill said.

“We’re rather hoping that regulatory burdens will decrease somewhat under President Trump, but we’ll have to wait and see. We’re not counting on it.”